It's time

It's time.  A few weeks ago Macro Man noted that he was agnostic as to the next 3-5% in the SPX, observing that the technical possibilities of another W formation were "deferred not destroyed".  In the ensuing period Spooz have risen sharply to the top of his range of indifference, tilting the balance of risk in the process.  From here he is shifting to a better seller of strength; among his reasons for doing so include the following:

* Positioning.  At 1950, you could just about argue that residual shorts were hanging by a thread or that fast-money punters were fairly neutral.  Subsequent price action clearly indicates a covering of whatever shorts are left and a building a tactical longs.  While there likely remains scope for marginal buying, the balance of risk has shifted towards the marginal trade being a sale rather than a purchase.

* Option expiry.  All those quarterly equity and index puts purchased during the downdraft earlier this year expire worthless this morning.  You could argue that they haven't had much influence on the delta of portfolios for a few weeks now, and that's correct.  Nevertheless, they showed up on risk reports....and now they don't.  That protection will need to be repurchased at some point, injecting some negative delta into the market.

* Inflation is not good for equities.  There is a school of thought that if the Fed is going to play fast and loose with its goalposts and produce higher inflation, this reflation trade should be good for stocks.   While you can certainly argue that this will be the case for certain sectors such as resources, the empirical evidence points overwhelmingly in the opposite direction for the market as a whole.  After all, the entire post-crisis period has been an environment of low inflation, and the S&P has done stunningly well.   Are we now to believe that higher inflation is also good for stocks?    Think that way if you wish, but Macro Man will rely on the work that has served him so well in the past.

* We're nearing the top of the range.   Simply put, the closer to we are to the highs, the more compelling the risk/reward of short sales becomes  Macro Man has noted previously that in rangebound markets JSTFR works just as well as JBTFD; better, in many ways, given the speed of recent descents.  While 5% from the highs isn't the place to strap on a max short, it is the place to pare longs and form a plan for scaling into shorts.   That is what Macro Man is doing.

* The W is finished.  Macro Man first sketched out the roadmap for a W shaped recovery a month ago.   While mindlessly following analogues can be a dangerous business, in many cases they can provide useful insights into possible roads ahead.  This has clearly been one of them.  How closely has this W followed the last one?   Astonishingly so, both in terms of price and time.  In fact, from the breakdown point both Ws have travelled nearly the exact same path in an identical amount of time.   Why might this be important?  Because today marks the end of the previous W, both in terms of time and price.

In fairness, the current one has another 30 points or so to go before hitting its proper target, and it would be churlish to expect the two formations to endure for exactly the same number of days.  But the underlying point is that we're close to the technical objective, after which it would be natural to expect a consolidation and correction.    In conjunction with the other factors noted above, it makes a compelling case for cashing out on longs and layering offers above to scale into shorts with a stop at new highs.

As for the USD, what should we expect there?  Clearly from a positioning standpoint there has been quite a bit of pain, but what about from a fundamental perspective?  Obviously there are many dollar crosses, each with its own idiosyncratic factors that drive.   Let's stick with the big dollar, therefore, and have a quick look at EUR/USD.

If we posit that EUR/USD is ultimately driven by policy, we can drill down and isolate the monetary stances of the Fed and ECB by looking at relative shifts in the balance sheet and at interest rate differentials- in this case the difference in 1y1y swap rates, which generally approximate rate cycle expectations.

A simple model that looks at the relative change in balance sheet sizes over the past six months and the difference in 1y1y yields appears to do a reasonable job of explaining levels in EUR/USD.  According to this simple model, the equilibrium level of the euro is currently 1.1390, a rise of 104 pips over last week.  While this is hardly an open and shut case, as a quick and dirty exercise it does suggest that there is little compelling case for a further larger depreciation of the dollar.

What if we regress changes rather than levels?  Macro Man looked at weekly changes in relative balance sheet size and weekly changes in the rate spread as explanatory variables for weekly changes in EUR/USD.   As you'd expect, the correlation is substantially lower, though still solid for such a simple model (R^2 of 0.24 versus 0.72).

Interestingly, this model suggests that EUR/USD should have rallied 1.3%, versus the 1.5% that it has actually done.  Again, the message here is that the dollar has already done what's expected of it based on shifts in policy expectations.   It's easy to forget just how little was priced into the US short end a few weeks ago; naturally, if we were to return to those levels, the outlook for the dollar would be much worse.   Even at the recent highs in short term rate expectations, however, the market was pricing in less than is suggested by the dot plot.   Of course, with two more SEPs to come before December, there remains ample time for further downward shifts in both the dots and short rates.


If the USD short end does manage to stabilize, then it may be quite difficult to argue for much more dollar weakness against the euro.  Of course, it's easier to see it happening against currencies enjoying a nice terms of trade bounce, though obviously a lot has been priced already.  Macro Man said after the ECB that he didn't see much value in participating in the euro.  In retrospect, that was wrong- it was a nice trade from the long side.    That being said, if and as more shorts get squeezed towards 1.15, it will look increasingly compelling to re-enter shorts barring a total meltdown in US short end yields.

P.S.  If any of the G20 conspiracy theorists tells you that the low USDCNY fix "proves" that the Fed was throwing a bone to China, ask them why the RMB has made new lows against its basket since the Fed announcement?